1. Chapter 14 Determinants of the Money Supply

2. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-2 The Money Supply Model Define money as currency plus checkable deposits: M1 The Fed can control the monetary base better than it can control reserves Link the money supply (M) to the monetary base (MB) and let m be the money multiplier

3. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-3 Deriving the Money Multiplier I

4. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-4 Deriving the Money Multiplier II

5. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-5 Deriving the Money Multiplier III

6. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-6 Deriving Money Multiplier: m=M / MB R = RR + ER RR: required reserves RR = r  D ER: excess reserves R = (r  D) + ER R: total reserves Adding C (currency) to both sides R + C = MB = (r  D) + ER + C 1. Tells us amount of MB needed support D, ER and C 2. $1 of MB in ER, not support D or C MB = (r  D) + (e  D) + (c  D) = (r + e + c)  D Deriving the Money Multiplier IV

7. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-7 Money Multiplier: M = m × MB m < 1/r because no multiple expansion for currency and because as D  ER  Full Model M = m  (MB n + DL)

8. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-8 Intuition Behind the Money Multiplier

9. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-9 Factors that Determine the Money Multiplier Changes in the required reserve ratio r  The money multiplier and the money supply are negatively related to r Changes in the currency ratio c  The money multiplier and the money supply are negatively related to c Changes in the excess reserves ratio e  The money multiplier and the money supply are negatively related to the excess reserves ratio e

10. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-10 Factors that Determine the Money Multiplier (cont’d) The excess reserves ratio e is negatively related to the market interest rate The excess reserves ratio e is positively related to expected deposit outflows

11. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-11 Determinants of e 1.i , relative R e on ER  (opportunity cost  ), e  2.Expected deposit outflows, ER insurance worth more, e 

12. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-12 Open market operations are controlled by the Fed The Fed cannot determine the amount of borrowing by banks from the Fed Split the monetary base into two components  MB n = MB - BR  M = m(MB n + BR) The money supply is positively related to both the non-borrowed monetary base MB n and to the level of borrowed reserves, BR, from the Fed Additional Factors

13. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-13

14. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-14

16. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-16 Explaining Movements in the Money Supply Over long periods, the primary determinant of movements in the money supply is the nonborrowed monetary base, which is controlled by the Fed’s open market operations

17. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-17

18. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-18

19. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 14-19